It is common practice for a landlord to take a deposit from a tenant when letting a property to cover the cost of any damage caused to the property by the tenant. A deposit of this nature may be referred to as a security deposit, a damage deposit or a rental deposit. The landlord may also ask for a holding deposit in return for taking the property off the market while the necessary paperwork is undertaken.
This article looks at the different types of deposits and the way in which they are treated for tax purposes.
It is normal practice for landlords to take a security deposit from tenants when letting residential property. The purpose of the deposit is to cover items such as damage to the property that extends beyond normal wear and tear, the cost of having the property, including the carpets, professionally cleaned, removing any rubbish from the property, unpaid rent and such like. The items covered by the security deposit should be stated in the letting agreement.
The deposit charged can be up to two months’ rent, although in practice six weeks’ rent is common.
Deposits taken by a landlord or agent for an assured shorthold tenancy in England or Wales are protected by Government authorised schemes. There are three possible schemes:
• the Deposit Protection Service scheme;
• the Tenancy Deposits Solution scheme; and
• The Dispute Service scheme.
To remove the need to go to court to settle disputes over retention and repayment of the deposit, each scheme features an alternative dispute resolution service. In the event that there is a dispute regarding the repayment of the deposit in the case of damage or unpaid rent, the alternative dispute resolution service will arbitrate. The burden of proof falls on the landlord or agent, who will need to provide evidence to support their claim that all or part of the deposit should be retained. If there is no dispute, the tenant’s deposit should be returned to the tenant at the end of the tenancy.
The extent to which the deposit is included as income of the rental business depends on whether all or part of the deposit is retained by the landlord. In a straightforward case where a security deposit is taken by the landlord, held for the period of the tenancy and returned to the tenant at the end of the rental period, the deposit is not included as income of the property rental business.
However, if at the end of the tenancy agreement the landlord retains all or part of the deposit to cover damage to the property, cleaning costs or other similar expenses, the amount retained is included as income of the property rental business. The retained deposit is a receipt of the business in the same way as rent received from the tenant.
However, the actual costs incurred by the landlord in making good the damage or having the property professionally cleaned are deducted in computing the profits of the business.
The retained deposit is reflected as rental income of the property rental business for the period in which the decision to retain the deposit is taken, rather than for the period in which the deposit was initially collected from the tenant.
Bill purchases a property as a buy to let investment. He lets the property out in September 2009. He collects a security deposit of £1,000 from the tenant. The terms of the deposit are set out in the tenancy agreement.
The let comes to an end in September 2011. When checking out the tenant, it transpires that the tenant has failed to have the carpets professionally cleaned, as per the terms of the agreement, and also that he has damaged a door, which needs to be repaired.
After discussion, Bill and the tenant agree that Bill will retain £250 of the deposit to cover cleaning and repair costs. The balance of the despot (£750) is returned to the tenant in October 2011.
Bill spends £180 having the property professional cleaned and £75 having the door repaired.
Bill prepares accounts for the property rental business to 31 March each year.
When preparing accounts for the year to 31 March 2012, Bill must include as income the £250 retained from the tenant. However, he can deduct the actual cost of cleaning the property (£180) and repairing the door (£75). As the amount actually spent (£255) exceeds the amount retained, he is given relief for the additional £5 in computing the profits of his property rental business.
The balance of the deposit returned to the tenant is not taken into account as income of the business.
As stated in the article on use of the property rental toolkit in our September issue, HMRC recognise that accounting for deposits can sometimes cause problems. Guidance on income that should be taken into account in computing the profits of a property rental business can be found in their Property Income Manual at PIM1051 (see www.hmrc.gov.uk/manuals/pimmanual/PIM1051.htm).
Holding deposits are another form of deposit commonly taken by landlords, particularly in periods where the letting market is buoyant and demand for property is high. As the name suggests, a holding deposit is paid by the tenant to secure the property while the tenancy agreement is signed. In return, the landlord will take the property off the market.
A holding deposit is usually in the region of one week’s rent. The terms governing the use of the deposit and the circumstances in which it may be retained by the landlord should be set out in a holding deposit agreement so all parties know where they stand.
In the event that the let falls through and under the terms of the agreement the landlord retains some or all of the deposit as compensation for the inconvenience and costs incurred in relation to the prospective let, the amount of the retained deposit should be included as income of the property rental business. However, the landlord would be able to claim a deduction for any costs actually incurred in relation to aborted let, such as advertising or legal fees.
In the event that the let goes ahead, the holding deposit would either be returned to the tenant or used to form part of the security deposit (see above). If the holding deposit is returned, it does not form part of the income of the business. Where the holding deposit is used as part of the security deposit, as explained above, it is only taken into account to the extent that it is retained by the landlord to cover damage etc. at the end of the let.
As a general rule, deposits taken from tenants only form part of the income of the property rental business to the extent that the deposit is ultimately retained by the landlord. Any deposits that are merely held on the tenant’s behalf before being returned to the tenant are not taken into account as income. On the other side of the coin, a deduction is given for any costs actually incurred by the landlord in making good damage etc. covered under the terms of the deposit agreement.
By Sarah Bradford